The recent surge in foreign government investing in the U.S. economy, particularly through Sovereign Wealth Funds, has prompted the Internal Revenue Services (“IRS”) to modify the existing Section 892 regulations regarding taxation of U.S. income earned by foreign governments. In a nutshell, Section 892 exempts foreign governments’ income from investing in U.S. stock, bonds and certain financial instruments; other types of income are not exempt. Furthermore, if a government controlled entity conducts any commercial activities anywhere in the world, none of that entity’s income can be exempted under Section 892.  This is commonly referred as the “commercial activities prohibition”.  However, the IRS provides a number of exceptions to this commercial activities prohibition. The purpose of the proposed regulations on November 2, 2011 is to expand the commercial activities exceptions in the following ways:

  1. Permit a foreign government controlled entity to claim Section 892 exemptions despite of the fact that the entity may have engaged in some amount of commercial activities,
  2. Permit a foreign government controlled entity investing and trading in financial instruments to claim Section 892 exemptions regardless where such instruments are held,
  3. Provide that mere disposing of U.S. real property interest is not considered commercial activities for Section 892 purpose, and
  4. Provide that commercial activities of a partnership will not be attributable to a limited partner.

Before the proposed regulations become finalized, the IRS and the Treasury are accepting public comments on or before February 1, 2012.


Section 892 of the Internal Revenue Code exempts U.S. income tax for certain types of income earned by foreign governments and their wholly controlled entities and Sovereign Wealth Funds.  Specifically, the practical benefit of Section 892 is with respect to

  1. U.S. source dividend income;
  2. U.S. source interest income that is not subject to statutory exemption; and
  3. gain on disposition of interests in U.S. real property holding companies.  Taxation of U.S. dividend and interest may also be affected by relevant treaty provisions.

The boundary of the Section 892 exemption is shaped by two competing policies: the long standing doctrine of sovereign immunity, or that government do not fall under each other’s jurisdictions, and a countervailing concern that the tax law should not favor commercial activities conducted by government or government owned enterprises. Accordingly, only the passive income of foreign governments is entitled to Section 892 exemption. Income derived from commercial activities or received from government controlled commercial entities is not exempted. The IRS defines commercial activities as activities that are “ordinarily conducted with a view towards the production of income or gain,” regardless whether such activities rise to the level of a U.S. trade or business.

Along this line, Section 892 regulations draw a distinction between income earned by entities that are integral parts of the foreign governments and entities controlled by the foreign governments. An integral part of a foreign government is an entity that constitutes a governing authority of that foreign country.  A treasury or finance department is an example of an integral part of a foreign government. If an integral part of a foreign government engages in commercial activities, it will lose the benefits of Section 892 exemption only on the portion of its income from commercial activities.  Its income from passive investment in the U.S. is still exempted.

A controlled entity is any entity that is separate in form from a foreign government, but is directly or indirectly controlled by the foreign government.  A sovereign wealth fund is an example of a controlled entity. This would be a government investment vehicle funded by foreign exchange assets, but that manages those assets separately from the official governmental reserves. If a controlled entity engages in any commercial activities anywhere in the world, none of its income would be exempted under Section 892, including passive income from investment in stock and bonds.

The purpose of treating a government controlled entity differently from the government itself is to prevent tax subsidies to commercial activities conducted by foreign governments. However, this absolute prohibition of commercial activities for controlled entities has presented many administrative difficulties without meaningful benefits.


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